Macro outlook – Looking beyond the winter
- The good news of the vaccines insures us against indefinite “lockdown/reopening” cycles, but we do not expect a proper rebound for the world economy before the second half of 2021.
- To deal with the unavoidable GDP contraction in Europe and this US this winter, and fuel the ensuing recovery, more policy support is need. Central banks are doing their part. Fiscal policy may be more hesitant.
Choose your horizon
Our level of optimism at this juncture is dependent on the time horizon. We now know for certain that we are not sentenced to and endless repetition of lockdown/reopening cycles. Uncertainty on the roll-over of the vaccine is high but, in our baseline, “herd immunity” would be reached in most developed economies around the middle of 2021, allowing a permanent restoration of supply conditions. However, we still need to brace ourselves for some challenging months ahead, with a relapse in GDP which is already well underway in Europe as we write, and which is looming in the US.
Of course, we could choose to look through the next three to six months as a mere bad dream. This is what equity markets are largely doing. An issue though is that the quality of the rebound from the second half of 2021 onward will be to some extent dependent on the depth of the ongoing recession and the quantum of policy protection governments and central banks will offer. Some decisions need to be made urgently.
We are convinced that central banks will be successful in creating the right conditions for massive fiscal support. Some political/institutional issues may however impair governments’ capacity to take advantage of this favourable environment. Thinking about how an “exit strategy” from extraordinary policy support could shape up would in fact help governments and central banks make their decisions now. This could be the “big debate” of the end of 2021.
The μ shape recovery
Coming up with intuitive descriptions for the trajectory of economic growth in the current pandemic has become a cottage industry. Let’s start with two shapes which have become impossible, or at least very unlikely.
We now know that a “V-shape” recovery did not materialise. We never believed in it in the first place because, even in the absence of the “second wave”, our view always was that after the spectacular rebound upon reopening, lagged demand-side impairments, channelled through the labour market and firms’ financial position, would slow GDP growth. We note that even China, which so far has avoided a “second wave”, private consumption is still “below trend”.
Does this mean we are in a “W” shape trajectory? Yes, but only with a shallow second leg. The best analogy we can think of is the Greek letter μ. Four factors will make the winter contraction less painful:
First, large swathes of the world economy are not affected by the pandemic at this stage. When Europe went into its first lockdown, Chinese activity had not yet normalised. At this stage there is no sign that we need to brace ourselves for a second wave there. World demand should hold better. This is good news for an export-reliant region such as the Euro area.
Second, even where the second wave is in full swing, lockdowns are less stringent. Our forecasts assume that the impact of Covid-suppressing measures and behavioural changes on activity will be roughly half of what it was at the last peak and so far, this seems to be confirmed by the message from real-time indicators such as Google activity reports. Lockdowns are also at this stage expected to be much shorter.
Third, businesses are much better prepared than during the first wave. They have been able to test their capacity for mass remote-working, and where on-site activity is permitted, sanitary protocols are already in place.
Fourth, the first wave came with a brief but intense financial turmoil, which added to the generic sense of uncertainty. Now that central banks have demonstrated their capacity to rein in volatility, financial institutions, corporates and households should feel more secure.
But symmetrically we expect the ensuing rebound to be shallower than what was observed last summer. Governments will have learned from their mistakes last spring upon reopening too fast, not least because lockdowns will end in wintertime when pressure on healthcare capacity is high. Lockdowns are likely to give way to easier restrictions, not outright reopening. In the US, the federal level has little direct impact on how Covid-suppressing measures are implemented on the ground, but it can “nudge” the local authorities. Joe Biden is likely to take a more hands-on approach than his predecessor. In our baseline, governments won’t take the risk of a “third wave” until vaccination ensures “herd immunity” around the middle of the year.
Calibrating the speed of the recovery in the second half of the year is difficult. In a “rosy” scenario, households would quickly catch-up on spending and the bulk of the savings overhang accumulated in 2020 would find its way back to consumption. In a similar fashion, firms would immediately step up their investment effort. We are more circumspect. To some extent, the recent rise in savings is an artefact. In many advanced economies income has been propped up by a massive fiscal stimulus (particularly in the US where the CARES act injected 10% of GDP in the economy). In October 2020, US personal income fell on the month as the fiscal push is fading. In Europe, the true state of the labour market is much worse than what the usual indicators would suggest: many workers remain on their firms’ payrolls thanks to generous part-time unemployment benefit schemes. They keep workers attached to their employers which is a good thing to prepare the recovery, but (i) this does not help the “newcomers” to the labour market and (ii) there could be a “backlash” when the schemes are wound down. On the business side, decision-makers will have to factor in the steep elevation in corporate debt in 2020 as well as ongoing uncertainty around the likely strength of demand.
We also need to be realistic about world demand. During the Great Recession of 2008/2009 China accepted to act as an engine of global growth by over-stimulating domestic demand. While the Chinese economy has normalised nicely in 2020, Beijing has remained prudent with its policy-mix. We think western exporters should count on solid, rather than stellar Chinese demand in 2021.
Calibrating policy support
The impact of monetary policy on the economy through the traditional channels has probably exhausted by now (interest rates were already low to start with) and the extension of QE in the spring of 2020 to new asset classes (e.g. corporate bonds in the US, commercial paper for both the Fed and the ECB) had more to do with nipping the financial turmoil in the bud than about stimulating the economy per se.
However, monetary policy remains crucial because it is what makes fiscal policy possible, free from any market-made tightening in financial conditions. This was expressed in no ambiguous terms by Christine Lagarde in her policy speech at the ECB’s annual conference: “While fiscal policy is active in supporting the economy, monetary policy has to minimise any “crowding-out” effects that might create negative spill overs for households and firms. Otherwise, increasing fiscal interventions could put upward pressure on market interest rates and crowd out private investors, with a detrimental effect on private demand”. This is akin to “implicit yield control”. We expect the ECB to extend in duration and size of its Pandemic Emergency Purchase Programme until the end of 2021 at least. The Fed is clearly in a similar mindset, judging by Jay Powell’s repeated calls for more fiscal action.
Will these calls be heard? While we don’t doubt fiscal policy will remain accommodative in the US and Europe in 2021, there is a wide margin of uncertainty on the quantum of such actions. In the US, if the Democrats win the two remaining Senatorial races on 5 January 2021, their fiscal stimulus programme of 10% of GDP will be in play. If they don’t, they will have to find a compromise with the Republicans who currently hold to their $500bn red line (2.5% of GDP). $500bn is no small change. It would be enough to avoid a “cliff” for emergency unemployment benefits and channel enough federal money into local authorities to avoid a mandatory fiscal tightening of 1.5% of GDP in this layer of government. In our baseline, the fiscal push would stretch to $1tn – the Republicans reacting to the winter GDP contraction – but the level of uncertainty is high. Moreover, the longer-term fiscal boost that Biden campaigned on would be highly unlikely to materialise without Democrat control of the Senate.
In Europe, the Next Generation pact should allow for significant fiscal support, even if it will roll out only slowly over the coming years. It may become more effective in prolonging the recovery into 2022 than in kickstarting it in 2021, but political difficulties continue to impair its roll-out (as we write, we still don’t know if a deal will be struck with Hungary and Poland, unblocking the EU budget). In general, some European governments seem to remain cautious with the quantum of fiscal support, except for Germany which is making full use of its massive room for manoeuvre.
Governments with shakier debt sustainability conditions do not want to count too much on permanent ECB forbearance, probably rightly so. There is a debate to have on how cooperation between fiscal and monetary policy could continue beyond the pandemic emergency. Governments need to be convinced that the central bank will take its time to normalise its stance so that they are not forced into recovery-killing crash fiscal retrenchment. Symmetrically, the central bank needs to be reasonably confident governments will engage in fiscal consolidation when the economy is on a sounder footing. This calls for an overhaul of the European fiscal surveillance framework. There might be some volatile moments in late 2021 when the market questions the ECB’s policy beyond PEPP.
We note that in some EMs, the room for manoeuvre on accommodation is scarce, with inflation surging in a few cases (Turkey, India, Mexico to a lesser extent). However, this is not a general feature. We are broadly constructive on EM, where GDP would grow by 5.5% in 2021, more than offsetting the 2.9% loss of 2020. In the developed world, a significant “GDP deficit” would remain, the rebound of 4.6% not offsetting the 5.9% contraction of 2020.
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